Contract Estimated Cost to Complete

The Estimated Cost to Complete function is used to adjust the accrued revenue and expenditure that has been posted through to the income statement. It is focused on the values that have been posted through and accrued within the income statement.

In Contract processing, the revenue recognition process, which accrues the income and expenses through to the income statement, is carried out via the Process Contract Lines function. This function uses the existing Job lines as the basis for recommending the value of work and revenue to be accrued into the income statement, although there are ways to adjust the revenue value. The line also determines the value of the costs that will be posted through to cost of sales. The Job lines however, reflect transactions or work that have occurred.

The Estimated Cost to Complete function allows for adjustments to be processed based on cost or revenue elements which may not have been incurred at the point in time when the assessment is made. As an example, during the project, the project manager may become aware of a cost that had not been anticipated. Being that the project is a fixed price project, that cost cannot be recovered from the customer and will have a material effect on the profitability of the project. The Job currently does not reflect the cost as the cost has not been incurred, and as such the income statement profitability has not been impacted.

The Estimated Cost to Complete function allows the project manager to incorporate the cost into the future planning of the Job and update the current financial reporting to reflect the impact of the cost. However, in order to adhere to accounting guideline, the effect of the cost that the project manager is aware of should be taken into account from a financial reporting perspective as soon as the company is aware of it.

The estimated cost to complete assessment is a point in time assessment. Essentially, the project manager, or whomever is responsible for the project, assesses from a revenue and cost standpoint, what is involved to complete the project.

This assessment is then combined with the actual results on the project achieved to the same data to establish the anticipated profitability of the project completion. This forecast profitability is then compared to the current recognized profitability, and a recommendation is calculated to post an adjustment to cost or revenue to reflect the anticipated future profit margin.

Due to the fact that the assessment of the revenue and cost are a point in time assessment, and conditions may change over time, the adjustment that the system posts to either costs or revenue, and auto-reversing journal entries are set to reverse on the first day of the next financial period defined inside SAP Business One.

Adjustments can be posted to either the accrued revenue or the accrued expenses. However, an adjustment should not be processed to both based on the same estimate. It is important to be aware that the estimated cost to complete processing is not a required process in Contract processing in Eralis Job. It is generally used in longer term, high value Contract Jobs.

Illustrated Example

The following example is intended to provide further understanding of the calculation that takes place when the system provides recommendations for the journal adjustment.

The Job in this example is a fixed price Job with a reflected revenue of $100,000 and costs of $60,000 resulting in an anticipated margin of 40%.

As at the date when the estimated cost to complete function was being run, total revenue of $60,000 had been accrued and total costs of $45,000. This resulted in an actual margin obtained of 25%.

The project manager assessed what was required to complete the project, having become aware of certain unanticipated costs. His assessment for completion was revenue of $40,000, which was all that was available due to the fixed price nature of the contract, along with costs of $37,000 leaving the completion margin of only 7.5%.

The summary of the project reflects that initially the project was planned to make a 40% margin, however currently the project is reflecting a 25% margin in the income statement and is only anticipated to generate a 7.5% margin through to completion.

The overall forecast for the project is revenue limited to $100,000 and incurred costs of $82,000, with the actual incurred of $45,000 and the estimate to complete of $37,000 and an overall forecast profit margin on the project of 18%. Currently the income statement reflects a profit margin of 25% however, the company is only projecting to make an 18% profit at completion of the project.

Therefore, the Estimated Cost to Complete function will recommend adjustments to either the revenue or expenses that will result in an 18% profit margin being reflected in the income statement for the project now. This will provide more accurate financial reporting on the performance of the company.

The cost adjustment that the system will recommend is based on the fact that revenue will not be changing and will remain at the recognized level of $60,000. Therefore, the adjustment will be to calculate what costs should be based on $60,000 revenue to give an 18% profit margin.

The first step is to calculate what an 18% profit would be on $60,000 which is calculated by multiplying $60,000 by 18% and will return a total of $10,800.

The second step is to calculate what the cost would need to be based on the $60,000 revenue to return a profit of $10,800, which is calculated by deducting $10,800 from $60,000 to return a result of $49,200.

The adjustment that needs to be posted is then the difference between the required cost and the actual cost, which results in the need for an increase in the accrued cost of $4,200.

For the more mathematically inclined this can also be calculated with the formula of (((current cost - revenue) x 1) - required margin ) / 100. A negative result indicates an increase to the cost is required, while a positive indicates a reduction in the cost required.

The calculation for the revenue adjustment is based on a similar premise, except that the calculation is based on establishing what the revenue should be while maintaining the actual cost incurred in order to achieve an 18% profit margin.

The formula to calculate what the revenue should be calculated is ((current costs / 1) - required margin) / 100 or in the case of our example $45,000 divided by 1-0.18 which returns a value of $54,878.05 as the revenue amount. This will necessitate a decrease in the revenue value of $51,2195

Once again, the formula to calculate the adjustment can be expressed as the current revenue less the current cost divided by 1 minus the required margin divided by 100.

The journal entry generated for the cost transaction results in a debit to the profit recognized account, which is defined on the Contract/Settlement tab of the Eralis Job System Initialization screen, and a credit to the income statement cost of goods sold account, defined as the default cost of sales account on the header of the Master Job.

The journal entry for the revenue adjustments is very similar in that the debit is processed to the profit recognized account while the credit is posted through to the sales General Ledger accounts as defined in the Default Sales Account field on the Master Job.

It is important to note that, in the journal details provided, the debit and credit accounts will always remain constant no matter what the value of the adjustment. For example, if the cost need to be increased, the process will still do a credit to the cost of goods sold account; however, the value will be a negative amount which has the same effect as debiting the cost of goods sold account.

It is also important to note that the Contract account is not impacted with the Estimated Cost to Complete processing, and we would recommend that you do not configure the system to use the same account for Contract Control and Profit Recognized. It is worthwhile keeping them separate, although we would recommend that the two accounts sit close to each other in the balance sheet.

One of the reasons to keep the two accounts separate is the Contract Completion process. The Contract Completion process sums the debit and credit values for a Contract in the Contract Control account to establish the under / over adjustment to be posted. If the same account is being used for the Contract Control and the Profit Recognized, and reversal has not been posted to a cost to complete adjustment, the calculation for the over / under recovery will be incorrect and the company will be left with either income or expenses trapped in the balance sheet.

Notes:

Due to the fact that the assessment of the revenue and costs are a point in time assessment, and conditions may change over time, the adjustments that the system posts to either costs or revenue are auto-reversing journal entries, set to reverse on the first day of the next financial period defined inside SAP Business One.

The estimated cost to complete processing is not a required process within overall contract processing in Eralis Job. It is generally used in longer term, high value contract jobs.

The journal entry generated for the cost transaction results in a debit to the profit recognized account which is defined on the contract / settlement tab of the Eralis Job system initialization screen, and a credit to the income statement cost of goods sold account defined as the Default cost of sales account on the header of the master job.

The journal entry for the revenue adjustment is very similar in that the debit is processed to the profit recognized account while the credit is posted through to the sales General Ledger account as defined in the default sales account field on the master job.

It is important to note that the contract control account is not impacted with the estimated cost to complete processing, and we would recommend that you do not configure the system to use the same account for contract control and profit recognized – it is worthwhile keeping them separate, although we would recommend that the two accounts sit close to each other in the balance sheet.